Commentary: Value Equity Strategy

• The market now has a clear call to action to solve the dual challenges of energy security and energy transition, requiring serious capital spending and innovation.
• Meeting this challenge will drive inflationary tailwinds, push up interest rates and pressure valuation multiples, but it will also create the biggest opportunity of this new market cycle.
• We added to defensive sectors during the quarter, including utilities and health care, looking for true diversification with low price correlations and lower price volatility.

Markets are often agents of critical change, especially when investors are motivated by a crisis. A crisis sparks people to acknowledge and tackle a major problem. The solution requires all things that a market can provide to sustain and drive change: a powerful narrative, lots of capital and time. Innovation is unleashed as people invest in all kinds of possible solutions, crazy ideas are funded, and luck and mistakes emerge as a byproduct of investors dreaming of profitable crisis solvers.

We are currently in a crisis, as the world has underinvested in energy and is now short of power. An energy crisis was emerging even before the horrific events in Ukraine. However, Ukraine unleashed a geopolitical crisis that reminded the world that power is one of the most effective strategic weapons. This crisis will spur much needed investments in energy, both legacy and renewable, as energy security is merged with an acceleration in energy transition. The big challenge is that energy security and transition will take time and trillions of dollars in investment. We think the dominant narrative and driver of the current market cycle will be in meeting this great challenge.

How did we arrive at the current crisis? In the post-2000 equity bubble, the dominant market narrative became the explosive demand for energy and commodities from emerging markets. The thesis that emerged was the economies of Brazil, Russia, India and China (BRIC) would overcome the six largest western economies by 2030. The growth of these BRIC economies would drive such great structural demand for commodities, especially energy, that supply would never catch up. Investors were underweight commodities during the late stages of the BRIC mania. It dominated daily financial news, was a focal point of every meeting, and was accepted as truth. How could we not realize the world was simply running out of stuff?

The major concern was that U.S. energy dependence was growing rapidly (Exhibit 1). The data showed that U.S. oil and gas reserves were rapidly dwindling, U.S. energy insecurity was growing rapidly and desperate solutions were emerging. As a result, the U.S. was preparing to import liquified natural gas (LNG), renewable investments in solar and wind were ramping up and some crazy energy companies were trying the impossible: fracking.

Exhibit 1: Energy Dependence and Independence

Fracking was originally a fringe idea that energy experts largely dismissed. But after a lucky mistake when a drilling team incorrectly mixed the fracking fluid, it produced surprisingly good results for natural gas. Then, to everyone’s surprise, it worked with oil. The U.S. became the largest oil producer in the world and enjoyed an incredible and unimagined path to its energy independence. The byproduct, of course, was that energy and most commodities endured a violent down cycle that relegated the BRIC narrative to the trash bin of market history.

This shift from a narrative of energy insecurity and scarcity during the BRIC market cycle to energy security and abundance during the FAANG market cycle was a critical swing factor. The shale boom and massive expansion of Chinese production, most of it powered by cheap thermal coal, were effectively massive deflationary catalysts. With nominal growth also held back by post Great Financial Crisis debt deleveraging in the private sector, investors focus shifted to finding secular growers that were completely insulated from anemic cyclical growth. In addition, these massive deflationary tailwinds freed monetary policy from inflationary concerns, as the Fed “put” became essentially costless. This allowed interest rates to fall to 5,000-year lows and an ocean of central bank liquidity to flood the globe.

"The challenge is that energy cycles are measured in years, not months." 

There is an inescapable cycle around energy: extrapolation of scarcity and abundance ultimately drives the opposite reality as we under- and overinvest. During the latest cycle of energy abundance, we again expected to have excess energy, and concern shifted away from energy security to the mounting existential crisis of climate change. We had to quit dirty energy and do it quickly. As a result, energy capital spending collapsed, and we ended up in a familiar spot. Supply growth started to shrink relative to demand, and this imbalance accelerated as demand recovered to record levels as we recovered from the COVID-19 collapse.

This brings us to the present. Even before Ukraine, Europe was dealing with an energy crisis with spiking natural gas and oil prices. Most commodity prices, especially key enabling metals for the energy transition, were also increasing dramatically as demand was exceeding supply. Then the Russian invasion happened, and the crisis became a full-on inflationary calamity.

The challenge is that energy cycles are measured in years, not months. This is especially true with the current cycle as the capital spending response to higher prices has so far been extremely muted. Solving the challenges of energy security and energy transition will require serious innovation as well as experimentation.

However, the market now has a clear call to action to make Europe energy independent, accelerate the energy transition and take “the power of power” away from Putin. These goals will be achieved, but it will require capital spending on renewable and legacy energy to more than double quickly by at least $1.5 trillion annually. This spending will allow three major things to happen:

• U.S. LNG exports will ramp up materially to allow Europe to turn away from Russian natural gas over the next several years. LNG technology is well-established, the U.S. is effectively the Saudi Arabia of natural gas, and Europe is desperate for this to happen. The key will be for U.S. policy to pivot. We think it will, but this is a risk factor. Besides offering Europe fundamental improvement in energy security, U.S. natural gas has roughly half the greenhouse gas (GHG) intensity of Russian gas (Exhibit 2). Additionally, the disruptive innovation of shale gas in displacing coal lowered U.S. emissions by 970 million metric tons from 2005 to 2019 (Exhibit 3). The GHG emissions reduction from coal-to-gas switching was greater than all other efforts combined in mitigating GHG emissions. Replicating this on a global scale with U.S. LNG exports is the quickest and most effective way to attack the goals of energy security and transition.

Exhibit 2: Appalachian Gas Offers a Superior Alternative

Exhibit 3: The Switch to Shale Makes a Difference

• Renewable investment must accelerate materially. This includes wind, solar, nuclear and hydrogen, renewable storage and carbon capture. As the innovation process accelerates, we think advances will be made that most experts would consider impossible today. The key is that we make the most of this crisis to drive change.
• Nuclear energy must be reconsidered. We evaluate the efficiency and power density of different energy systems by a ratio — energy return on energy invested (EROEI) — which measures the amount of usable energy delivered compared to the total energy used in its production. The higher the number the better, and nuclear leads the pack with an estimated EROEI of 75:1 compared to 50:1 for hydroelectric power, 30:1 for coal, 28:1 for natural gas, 19:1 for solar in sunny geographies, 16:1 for wind, 4:1 for solar in cloudy places like Germany, and at best 1:1 for ethanol. In addition, nuclear has no GHG emissions. The only two systems that should be eliminated are coal due to GHG emissions and ethanol because burning food is just not efficient. The key message is that we need a combination of energy systems to keep us stable while we transition. Moving to lower energy densities and efficiencies would pressure economic growth while feeding inflation.

We are still in the early part of a new market cycle that is being driven by massive change that the Ukraine crisis will reinforce and accelerate. Meeting the twin challenges of energy security and transition will drive inflationary tailwinds and higher interest rates and continue to pressure valuation multiples across financial markets. However, this change and these challenges will be the biggest opportunity of this market cycle.

"The Ukraine crisis reminded the world that energy is the ultimate geopolitical power." 

How are we, as valuation-disciplined investors, adapting to and positioning for the risks and opportunity of this change?

One of the biggest challenges of investing is that, in each market cycle, investors must surf the big wave of change and opportunity as market-beating returns are not normally distributed. FAANG stocks were obviously the big wave of the last market cycle, and we think that power and energy will be the big wave of this one.

Accordingly, we have almost 30% of the portfolio in power-related equities with the following breakdowns:

• About 10% of this exposure is in legacy energy companies, with the goal to produce the lowest-emission energy possible and continually improve on this metric. We added no new positions in this category during the quarter, but it grew organically as legacy energy stocks led the market. EQT, as an example, was up over 50% during the quarter as natural gas prices moved higher in both the spot market and futures curve. As the largest natural gas producer in the U.S., EQT is positioned to generate dramatic free cash flow and LNG demand for U.S. gas grows over the next decade.
• About 7% of the portfolio is allocated in companies that we consider to be enablers of energy security and transition. We added Baker Hughes during the quarter, the leading provider of turbo-compression technology and services for LNG and carbon capture. Even with recent stock price strength, the accelerating long-term growth from this capability suggested a higher and growing business value as Baker’s growth and returns accelerate over this market cycle.
• About 6% of the portfolio is in renewables. Despite the very promising outlook, many renewable stocks faced significant headwinds during the quarter. Long-duration growth stocks were punished by higher interest rates, but solar and wind stocks were also hit by supply chain issues that are temporarily slowing solar and wind deployments. We took advantage of the decline to add a new position in Enphase, which designs and manufactures a hardware and software platform for solar energy systems. Our valuation discipline makes it more challenging to buy into the pure-play renewable stocks, but we can leverage volatility to take advantage of short-term overreactions that push price below our valuation estimates.
• About 5% of the portfolio is in transitioning power companies, typically migrating from coal to renewables. We have been active in encouraging these transitions and added a new position in American Electric Power (AEP). AEP has the fastest planned renewable energy ramp in the U.S., with plans to both shrink coal and grow renewables by 50% each by 2030. This would drive an 80% emissions reduction, while supporting high single-digit earnings growth at a double-digit return.

Our primary goal is to invest in the spectrum of LNG, nuclear, solar, wind, storage, carbon capture and hydrogen where we can provide capital below intrinsic business value. The challenge over the next decade is that many of these companies will increasingly blend as they invest across the legacy to renewable power curve, with business value rapidly compounding for companies who can combine accelerating growth with an attractive return profile. Identifying the most successful of these will require our active approach, and we are fortunate to have an experienced team of excellent analysts that are focused on this dynamic and this rapidly emerging opportunity.

If power is the opportunity, the challenge is that inflationary tailwinds have made the “Fed put” much more expensive, and interest rates are rising across the yield curve while liquidity is draining. The result is higher volatility and lower valuation multiples. The silver lining is that higher interest rates have been good for value as a style, and the lowest earnings multiples have performed best even within value indexes (Exhibit 4). Our portfolio has been valued at a low-teens forward earnings multiple, which is about 20% below the respective value indices and we have achieved this without sacrificing fundamental strength in growth returns or capital strength.

Lower earnings multiples tend to be attached to cyclical companies like energy and financials, a phenomenon we refer to as value offense. The macroeconomic risk of value offense translates to higher stock price volatility, especially when recession risks rise. We still expect the U.S. economic recovery to continue as pent-up demand for services and travel is underway as COVID-19 cases have fallen dramatically.

Exhibit 4: Maximizing Performance Can Result in Shifts Toward Cyclical, Low P/E Investments

However, with the Fed getting aggressive and the Ukraine crisis hitting global growth, especially in Europe, we added to value defense during the quarter, looking for true diversification with low price correlations to value offense and typically much lower price volatility. We found these conditions met by AEP, which has an attractive renewable growth profile within a regulated utility with a favorable regulatory environment. We also added over 5% in the quarter to our health care weighting, as price-to-value gaps are the most attractive within value defense. For example, we added Pfizer after the stock corrected 25% during the early part of the quarter. We consider Pfizer cheap insurance against COVID-19, as the supply of its antiviral oral pill, Paxlovid, will ramp up over 2022. Paxlovid will help further mitigate stress on health care systems from COVID-19 infections and further enable global reopening. This will add to Pfizer’s economic windfall, which will provide the company with the optionality of deploying roughly $100 billion in cash. While this option comes with a risk, it adds to the defensive nature of the stock and was not an expensive long-term option at our purchase price.

Our main task as active valuation managers is to preserve and build long-term shareholder wealth. We do this by adapting to a constantly changing market environment and looking to be on the right side of big opportunities, such as the ones we are currently tracking in power and energy. Despite the tremendous challenges and complexities that the global energy transition entails, we remain optimistic that the world will be able to leverage this opportunity to propel itself to a position of abundant and cleaner power.

The ClearBridge Value Equity Strategy outperformed its Russell 1000 Value Index during the first quarter. On an absolute basis, the Strategy had losses across six of the 11 sectors in which it was invested during the quarter. The leading detractors were the consumer discretionary and industrials sectors, while the leading contributor was the energy sector.

On a relative basis, overall sector allocation effects contributed to relative performance while stock selection detracted. Specifically, stock selection in the information technology (IT), health care and materials sectors and an overweight to the energy sector benefited performance. Conversely, stock selection in the industrials, financials, communication services, consumer staples and consumer discretionary sectors and an overweight to the consumer discretionary sector weighed on returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were EQT, Pioneer Natural Resources, Devon Energy, Energy Transfer and Enphase Energy. The largest detractors from absolute returns were Fluence Energy, Synchrony Financial, Facebook, General Motors and Uber Technologies.

In addition to the transactions listed above, we initiated positions in Royal Gold and Mosaic in the materials sector, Cigna in the health care sector, Bloomin’ Brands and Alibaba in the consumer discretionary sector, XPO Logistics in the industrials sector and VMware in the IT sector. We also exited positions in Goldman Sachs in the financials sector, ON Semiconductor in the IT sector, Gilead Sciences in the health care sector, KION, Northrop Grumman, Eaton, Oshkosh and GXO Logistics in the industrials sector, Liberty Media SiriusXM in the communication services sector, Simon Property in the real estate sector and Goodyear Tire & Rubber in the consumer discretionary sector.